[Ajitesh Arya and Mitakshara Singh are the 4th year BA LLB (Hons.) students at NALSAR University of Law, Hyderabad]
In a bid to further tighten the noose on the investments coming in from China, Hong Kong, and other neighboring countries, the Ministry of Corporate Affairs (MCA) through notification GSR 410E dated 1 June 2022 has made amendments to the Companies (Appointment and Qualifications of Directors) Rules, 2014 (the “Company Directors’ Rules”). The Company Directors’ Rules now mandate that individuals holding the nationality of a country sharing a land border with India must obtain the necessary security clearance from the Ministry of Home Affairs (MHA) before they are appointed a director in an Indian company. Additionally, the notification now requires security clearance from the MHA even for an application seeking a Directors’ Identification Number (DIN). In this post, we argue that the amendment is not likely to further the apparent objectives of foreign direct investment regulation while rendering the position of the foreign investor precarious.
Press Note 3 of 2020
The recent notification has to be read in the context of Press Note 3 of 2020 amending the Foreign Direct Investment (FDI) policy, which mandated government approval for investments coming from countries sharing land borders with India. The Press Note saw the light of day amid the COVID-19 pandemic when the Indian economy was marked with entities facing unfavorable valuations. Thus, the Government introduced the concerned protectionist measure to prevent opportunistic takeovers of strategic industries and those with stressed assets.
The amendment covered FDI made by (i) any entity based in any bordering country of India; or (ii) any beneficial owner of the investment situated in or citizen of any bordering country of India. The Press Note 3 also applied to any direct or indirect transfer of ownership of any existing or future FDI, and any such subsequent change in beneficial ownership. The Press Note stoked considerable controversy. This led to even minor bona fide investments falling within the scope of scrutiny, thus prolonging the investment cycle and causing delays in timelines. We argue that in spite of these practical shortfalls, the FDI amendment made through Press Note 3 had a legitimate and rational nexus with the sought objective of preventing predatory takeovers. The amendment made to the Company Rules, however, lacks the same objective.
Objective of the Amendment
As an extension of the protectionist regime sought to be established by way of Press Note 3 of 2020, the concerned amendment relating to directors has been introduced. There was a concern that investors from neighboring countries, especially China and Hong Kong, had formulated a workaround to escape the FDI control regulations. It was found that such investors would set up a company in a foreign jurisdiction like the Cayman Islands or the USA and use those special purpose vehicles to route their investments into India without any restrictions. Then, in order to gain control, they would appoint individuals of their nationality to the board of directors. It is to prevent such directorship that the amendment has been introduced. We propose that this selective scrutiny of board appointments is not likely to have the inhibiting effect that is sought to be achieved, with a focus on the role of nominee directors.
When investments are made into companies, larger investors (not exclusively) prefer to exercise some control over their management and operations, in order to oversee the use of funds lent by them. To realize this requirement, the articles of association of most companies provide for the appointment of nominee directors. There do exist other enabling arrangements in order to facilitate similar appointments.
Even as the office of a nominee director has been held to be duty-bound to act in the best interests of the company in Tata Consultancy Services Ltd. v. Cyrus Investments Pvt. Ltd., in practical terms the director is still considered a representative of her nominators. The nominee director is often contractually bound to represent the interests of the nominator as long as the same is not contrary to the interests of the company. In the situation at hand, the foreign investors employing the evasive measures shall still be able to nominate directors through the special purpose vehicles making the investments in India. The nationality of such a director would hardly have an impact on the control being exercised in effect by the foreign investors. The nominee director could be an Indian citizen or a national not belonging to the neighboring countries and still be representative of the foreign investors’ interests. Thus, the strict scrutiny of board appointments in India might not necessarily lead to the desired goals of protection.
Additionally, the FDI regulations are well placed to capture the above-mentioned situation. The investment by an entity whose beneficial ownership lies with residents of neighboring countries would fall under the approval route. Therefore, at the risk of oversimplification, instead of introducing additional compliance requirements for directorial appointments, the FDI regulations could be more strictly implemented.
Increased Burden and Uncertainty
The amendment is likely to increase the burden on processing authorities, Indian companies relying on foreign investments, and foreign nationals seeking to become directors in India. This is because, firstly, the amendment is virtually silent on the scope of discretion granted to the MHA for the grant of security clearances. This opens up great scope for arbitrariness in decision-making and renders the appointment procedure highly uncertain. This also constitutes a case of excessive delegation in the absence of any indication as to the parameters to be employed.
The two-pronged approval process would, secondly, multiply the delays that genuine investment deals and deadlines are already faced with as a result of the uncertainty caused by Press Note 3. In the absence of any assurance that the investors would be able to appoint directors who would best represent their interests added to the uncertainties, fall-outs may be anticipated in the investment market. This is likely to cause sourness, especially with Indian start-ups which source a significant portion of their investments from India’s neighbours.
It is also pertinent to note that the concerned amendment only deals with new appointments of foreign nationals as directors. It is conspicuously silent about directors presently serving their term. With limited information, it can only be anticipated that on the expiry of their existing terms, the new rules are to be implemented for reappointments. This is cause for considerable uncertainty as to the temporal and qualificatory aspects of the issue.
Genuine Investor Interest
It is possible that genuine investors might have to consider the appointment of personnel as observers instead of appointing them as nominee directors to avoid the delays and additional steps involved. However, an observer does not possess the same powers (nor responsibilities) as that of a director. This essentially defeats the oversight interests that might be important in order to protect investors’ interests. Further, an observer is also denied certain benefits otherwise guaranteed to employees and directors of a company. For instance, rule 8 of Foreign Exchange Management (Non-debt Instruments) Rules, 2019 allows for an Indian company to issue stock options to its employees and directors, but disqualifies an observer from availing similar benefits. This might disincentivize foreign nationals from undertaking such roles of responsibility, further rendering the genuine investor without adequate protection and representation.
The appointment of foreign nationals to the boards of companies could arguably prove to be beneficial in the long run. There are suggestions that foreign director is likely to lead to better compliance with corporate governance measures, and bring in greater transparency and financial accountability. Recently, studies have also concluded that foreign directors contribute to environmental accountability, which aligns with the stakeholders approach towards directors’ duties adopted in India. Thus, to make a general argument in favor of promoting on-board diversity, not limited to gender but inclusive of race, ethnicity, or nationality is not ill-founded. Adequate restrictions based on, say, the proportionality of participation inspired by the US model might be adopted where necessary.
The concerned amendment aims to further the hold of the protectionism initiated with Press Note 3 of 2020. As demonstrated above, the amendment fails to meet that objective while increasing the prevalent uncertainty with respect to foreign investments coming in from neighboring countries. A better approach could be to explore alteration of the FDI Rules themselves in order to bring within their ambit the special purpose vehicles and shell companies being used to route investments into the country.
– Ajitesh Arya & Mitakshara Singh